“Tax-Affecting” Used by Both Valuation Appraisers

Estate of Aaron Jones v. Commissioner,

T.C. Memo. 2019-101

Three Additional Take-Aways

On August 19th the Tax Court ruled that “tax-affecting” provided a “more accurate account of the impact of the tax consequences” of a pass-thru entity’s in determining the fair market value under a willing buyer and willing seller construct. Click here for a summary of the case.

The taxpayer operated Seneca Sawmill (SSC), a lumber manufacturing company and owned timberlands in a limited partnership (SJTC) to
provide a consistent supply of timber. The taxpayer made gifts of interests in both entities in 2009.  

Primary issue at hand: S corporations are subject to shareholder level taxes on their pro-rata share of income that is reported by the corporation. Further, these shareholders avoid dividend and capital gains taxes to the extent these are accumulated by the corporation.

The question then is how to value S corporations considering their benefits and their drawbacks. The controversy over the valuation of S corporations took the full attention of the valuation community and advisors with Walter Gross v. Commissioner, T.C. Memo. 1999-254. Ruling that the practice of “tax-affecting” earnings of an S corporation the appraiser created a “fictitious tax burden, equal to an assumed corporate tax rate of 40%.” Because the entity does not pay a tax, the Court stated, the rate should be zero. The principal benefit to the shareholders from an S corporation “is a reduction in the total tax burden imposed on the enterprise”.

The IRS in subsequent cases continued to press and win on the issue of no tax-affecting allowed, see Wall, Adams, Heck, Dallas, Gallagher and Giustina cases where appraisers could not convince the Tax Court of the need to tax-affect earnings and the reasons why.

Fast forward to the instant case, the primary issues to address by this Court were, should the asset-based approach or the income-based approach be used to value the two entities, tax-affecting, and the appropriate level of adjustment for lack of marketability. There were two other issues addressed, the use of 2009 revised projections and the treatment of intercompany loans between the two entities being valued.

From the opinion, the Court found that, Robert Reilly the taxpayer’s expert, advocated the use of tax-affecting and that it:

“…has more accurately taken into account the tax consequences of SJTC’s flowthough status for purposes of estimating what a willing buyer and willing seller might conclude regarding its value. His adjustments include a reduction in the total tax burden by imputing the burden of the current tax that an owner might owe on the entity’s earnings and the benefit of a future dividend tax avoided that an owner might enjoy…tax-affecting may not be exact, but it is more complete and more convincing than the respondent’s zero tax rate.”   

This case provides further argument and support for the use of tax-affecting and follows recent decisions in Kress v. United States and Cecil v. Commissioner, although this decision is still pending. In both instances, appraisers retained by both sides tax-affected earnings.

Interestingly, in Kress the IRS expert added an S corporation premium because of the advantages over C corporation status, but the Court found that there were disadvantages as well “including the limited ability to reinvest in the company and the limited access to credit markets”. Question: If faced with the same fact pattern in the Gross case would the same outcome occur – a no premium decision for S corporation status despite paying out substantially all the company’s profits in distributions?

See: Determining the Value of an S Corp

Beyond the tax-affecting issue there are three additional take-aways from the case:

1. Dividend Tax Avoided Tax Benefit
The Court favored the taxpayer’s appraiser who while tax-affecting income of both entities, also considered the benefit of avoiding the dividend tax and estimated the benefit to the partners of a limited partnership (SJTC). While the procedure to determine the benefit is not indicated, a “premium” of 22% was added to the value determined under two differing valuation methods. Mention is made of an empirical study covering the acquisition of S corporations. This may the Erickson & Wang study conducted in 2007.

Moving forward will the Service use the “premium” argument as a bludgeon in future cases involving tax-affecting? This is particularly important in the post-TCJA environment where tax rates are materially different than those used in this case and which may in fact create no premium!

2. Discount for Lack of Marketability Discussion
Both appraisers applied a discount for marketability discount (DLOM), the IRS appraiser at 30% and the taxpayer’s appraiser of 35%. The difference of only 5% is important as the various studies cited the taxpayer’s appraiser are akin to what many appraisers use in determining this adjustment.

Importantly, Reilly provides compelling evidence and support for the adjustment by citing restricted stock surveys, pre-IPO studies, option pricing models and a DCF method that is not identified (possibly Mercer’s QMDM?), in further refining the magnitude and support for the adjustment.

Providing a qualitative slant to the analysis Reilly addresses the Mandelbaum factors which are cited in a TC Memo back (1995) as indicated by Judge Laro in the decision. The factors among others include the characteristics of the interests being valued, the terms of the Buy-Sell Agreement, the potentially indefinite holding period, and the unpredictability of distributions among other factors to determine the adjustment.

The message to appraisers is clear, considering that the marketability discount is arguably the largest adjustment to value in many instances, merely citing restricted stock studies and pre-IPO studies and resolving them to an average will not suffice. Consideration of all current empirical, quantitative and qualitive factors that could influence the adjustment is critical to having a sustained opinion.

3. A Jab at Giustina
Citing Giustina, the Court found that the initial decision in this case accorded a weighting of the income approach and the asset-based approach (75% and 25% respectively), but noted that the Ninth Circuit in its reversal indicated that we hold that “no weight should be given to an asset-based valuation because the assumption of an asset sale was a hypothetical scenario contrary to the evidence in the record”.

Further, the Ninth Circuit states in its decision:

“As in the Estate of Simplot v. Commissioner, 249 F.3d 1191, 1195 (9th Cir. 2001), the Tax Court engaged in imaginary scenarios as to who a purchaser might be, how long the purchaser would be willing to wait without any return on his investment, and what combination the purchaser might be able to effect, with the existing partners”.

Could this have been a replay of Giustina if the Court ruled in differently and found that the asset approach was preferred to the income approach?

Perhaps this is a victory at last for tax -affecting and a way forward?

Categories: Valuation

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